Capital Expenditure Decisions

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Capital Expenditure Decisions

Evaluation Criteria

Non Discounting

Discounting

Payback period

Accounting Rate of Return (ARR)

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Ratio/Benefit Cost Ratio ( PI/BCR)

Net Present Value

c1 c3 cn c2 NPV = + + + ........ c0 2 3 n (1 + k ) (1 + k ) (1 + k ) ( 1 + k )
ct NPV = c0 t t =1 (1 + k )
n

Where, C1, C2 represent the net cash inflow in year 1, 2 K is the opportunity cost of Capital C0 is the initial cost of investment n is the expected life of investment

Net Present Value

o

Acceptance Rule NPV n Accept NPV > 0 n Reject NPV < 0 n May accept NPV = 0 Evaluation of NPV method n It recognizes the time value of money n It uses all cash flows occurring over the entire life of the project n NPVs of the projects can be added NPV(A+B)=NPV(A)+NPV(B)-Value Additively Principle
n

NPV method is consistent with the objective of maximizing the shareholders wealth

Net Present Value

A m o u n t o u t s t a n de itnu gr n i no n h o u t sT t oa tna dl i an m o ue np ta y m e n B far loa m c e R t e g R t n Year b e g in n in g a m o u n t a t 1o 0u%t s t a n d i n cg a fs l h wa ts t h oe u et sn tda n d i n g o Rs Rs Rs Rs Rs 1 2500 250 2750 900 1850 2 1850 185 2035 800 1235 3 1235 1 2 3 .5 1 3 5 8 .5 700 6 5 8 .5 4 6 5 8 .5 6 5 .8 5 7 2 4 .3 5 600 1 2 4 .3 5 5 1 2 4 .3 5 1 2 .4 3 5 1 3 6 .7 8 5 500 -3 6 3 .2 1 5

Internal Rate of Return

ct 0= c 1 + )t 0 ( r t= 1
n
o

Acceptance Rule IRR n Accept r > k n Reject r < k n May accept r = k Evaluation of IRR method n It recognizes the time value of money n It uses all cash flows occurring over the entire life of the project n IRR method is consistent with the objective of maximizing the shareholders wealth

Internal Rate of Return

o

Unlike in the case of NPV method, the value additivity principle does not hold.
P r o je c t A B A+B C0 -1 0 0 -1 5 0 -2 5 0 C1 120 168 288 N PV @ 10% 9 .0 8 2 .7 1 2 1 1 .7 9 2 IR R % 20% 12% 1 5 .2 0 %

IRR method can yield multiple internal rates of return

Initial cost Net cash flow Net cash flow IRR

0 1 2

-20,000 90,000 -80,000 21.9% , 228%

Conflict in ranking
Different rankings given by the NPV and IRR methods can be illustrated under the following heads:
n n n

Size-disparity problem Time-disparity problem Unequal expected lives

Size Disparity Problem

P a r tic u la r s C a s h o u tla y s C a s h in f lo w s a t e n d o f th e y e a r, IR R (% ) k NPV

P r o je c t A -5 0 0 0 th e 16 2 5 0 25 6 8 1 .2 5

P r o je c t B -7 5 0 0 9150 22 10 8 1 7 .3 5

P r o je c t B - A -2 5 0 0 2900 16

Time Disparity Problem

C a s h F lo w s (R s .) P ro je c t C0 M N C1 -1 6 8 0 -1 6 8 0 C2 1400 140 700 840 C3 N P V @ 9 % IR R 400 301 1510 321
NPV Discount rate % 0 5 10 15 20 25 30 M Rs. 560 409 276 159 53 -40 -125 N Rs. 810 520 276 70 -106 -257 -388

23% 17%

Unequal expected lives (Common Time

Horizon Approach)
Pri u r atc l a I i i lota ( s n a u y R. t l ) Ya er 1 2 3 4 Sr i ei e yas ev lf ( er ) c Rqi e r t or t r e u d ae f e n r u
P j cA r et o Ya er 0 1 2 3 3 4 NV P P j cB r et o Ya er 0 1 2 3 4 NV P Cs fo ( s ahl wR. ) - 00 200 80 00 90 00 70 00 60 00 Pfc r Vat o 10 . 0 0 00 . 9 9 02 . 6 8 05 . 1 7 08 . 3 6 Tt lP ( s o VR. a ) - 00 200 77 22 73 44 55 27 49 08 46 01 Cs fo ( s ahl wR. ) - 00 100 80 00 70 00 - 00 100 80 00 70 00 Pfc r Vat o 10 . 0 0 00 . 9 9 02 . 6 8 02 . 6 8 05 . 1 7 08 . 3 6 Tt lP ( s o VR. a ) - 00 100 77 22 58 72 - 20 86 60 08 48 71 58 53

P j cA r et o 100 00 Cs I fo s fe t xs ahn w at r ae l 80 00 70 00 N i l N i l 2 1% 0

P j cB r et o 2 00 00

80 00 90 00 70 00 60 00 4

Unequal expected lives (Equivalent

Annual Value/Cost Approach)
EANPV =

N et p resen t valu e of th e p roject P V of an n u ity corresp o n d in g to life of th e p roject at giv en lcost o cap ita
D e t e r m in a t i o n o f N P V o f P r o je c t s A a n d B Y e a rs C F A T ( R s P V f a c t o r ( 0T. 1 0 a l P V ( R s )N P V ( R s ) ) ot) 1 -5 3 0 ,0 0 0 3 .7 9 1 1 ,1 3 , 7 3 0 1 3 ,7 3 0 1 -8 2 7 ,0 0 0 5 .3 3 5 1 ,4 4 , 0 4 5 1 9 ,0 4 5

P ro je c t A B

P r o je c t A B

D e t e r m in a t io n N P V (R s ) P V 1 3 ,7 3 0 1 9 ,0 4 5

of EANPV f a c t o r ( 0E.1 0N) P V ( R s ) A 3 .7 9 1 3 6 2 1 .7 4 5 .3 3 5 3 5 6 9 .8 2

Unequal expected lives (Equivalent

Annual Value/Cost Approach)
E q u iv a le n t A n n u a l C o s ts o f M a c h in e s A a n d B C o s t s ( R s ) P V f a c t o r ( 0 . 1 0 )d j u s t e d P V ( R s ) A M a c h in e A a c h in e B M P a r t i c u l a r s M a c h i n e AM a c h i n e B 0 (In itia l C o s t) 5 0 ,0 0 0 6 5 ,0 0 0 1 5 0 ,0 0 0 6 5 ,0 0 0 (O p e r a tin g c o s t): 1 -6 y e a rs (A ) 6950 4 .3 5 5 3 0 2 6 7 .2 5 1 -1 0 y e a rs (B ) 5700 6 .1 4 5 3 5 0 2 6 .5 8 0 2 6 7 .2 5 1 0 0 0 2 6 .5 L e s s : S a lv a g e v a lu e 6 th y e a r (A ) 2000 0 .5 6 4 1128 1 0 th y e a r (B ) 5000 0 .3 8 6 1930 P V o f to ta l c o s ts 7 9 1 3 9 .2 5 9 8 0 9 6 .5 EAC 1 8 1 7 2 .0 4 1 5 9 6 3 .6 3

Profitability Index
o

PI = PV of cash inflows Initial cash outlay Acceptance Rule PI n Accept PI > 1 n Reject PI < 1 n May accept PI = 1 Evaluation of PI method n It recognizes the time value of money n It uses all cash flows occurring over the entire life of the project n It is a relative measure of a projects profitability

Conflict in ranking
Year P ro je c t A (R s P ro je c t B (R s ) ) 0 -5 0 ,0 0 0 -3 5 ,0 0 0 1 4 0 ,0 0 0 3 0 ,0 0 0 2 4 0 ,0 0 0 3 0 ,0 0 0 P V o f c a s h in flo w (0 .1 0 ) 6 9 ,4 4 0 5 2 ,0 8 0 NPV 1 9 ,4 4 0 1 7 ,0 8 0 PI 1 .3 8 8 8 1 .4 8 8

Capital Rationing
Project X Y Z W Initial Investment (Rs crore) 3 2 2.5 6 NPV ( Rs crore) 0.6 0.5 1.5 1.8 PI 1.2 1.25 1.6 1.3

Project Z W Y X

Initial Investment (Rs crore) 2.5 6 2 3

NPV ( Rs crore) 1.5 1.8 0.5 0.6

PI 1.6 1.3 1.25 1.2

Payback Period
o

Payback Period (Constant annual cash inflows)

Annual Cash Inflow

Payback = Initial Investment

Acceptance Rule Payback Period

Accept Payback Period < Max. payback period set Reject Payback Period > Max. payback period set
o

Evaluation of Payback Period method

n

Simple to understand, easy to calculate and focus on risk

P r o je c t X Y

Fails to take account of the cash inflows earned after C a s h F lo w s (R s ) payback period

C0

C1

C2

C3

-4 0 0 0 -4 0 0 0

0 2000

4000 2000

2000 0

P a y b a c kN P V @ 1 0 % 2 y rs 806 2 y rs -5 3 0

Payback Period
n

Fails to consider the pattern of cash flows i.e. magnitude and timing of cash flows

P r o je c t X Y
n

C0 -5 0 0 0 -5 0 0 0

C1 3000 2000

C a s h F lo w s (R s ) C2 C3 P a y b a cN k P V @ 1 0 % 2000 2000 2 y rs 881 3000 2000 2 y rs 798

Administrative difficulties may be faced in determining the maximum acceptable payback period Not consistent with the objective of maximizing the market value of the firms share.

Accounting Rate of Return

ARR =

Average income

C a l c u la t io n o f A c c o u n t in g R a t e o f R e t u r n P e r io d 1 2 3 4 5 A v e ra g e (R s ) E B D IT 10000 12000 14000 16000 20000 14400 L e s s : D e p r e c i a t io n 8000 8000 8000 8000 8000 8000 E B IT 2000 4000 6000 8000 12000 6400 Taxes @ 50% 1000 2000 3000 4000 6000 3200 E B IT ( 1 - T ) 1000 2000 3000 4000 6000 3200 B o o k v a lu e o f In v e s t m e n t B e g i n n in g 40000 32000 24000 16000 8000 E n d in g 32000 24000 16000 8000 0 A v e ra g e 36000 28000 20000 12000 4000 20000 ARR 0 .1 6

Average investment

Accounting Rate of Return

o

Accept ARR >Min. rate set Reject ARR< Min. rate set
o

Acceptance Rule ARR

Evaluation of ARR method

n n

n n

It is simple to understand and use ARR can be readily calculated from the accounting data It incorporates the entire stream of income in calculating the projects profitability It uses accounting profits and not cash flows The averaging of income ignores the time value of money It uses an arbitrary cut-off yardstick

Investment decisions under inflation

Discount nominal cash flows at nominal discount rate or discount real cash flows at real discount rate. (1+Nominal rate) = (1+Real rate)(1+inflation rate)
C0 -10000 N P V @ 14% N P V @ 6.54% R eal C ash F low s (R s) C1 C2 3000 3000 -1258 266 C3 3000 C4 3000

C0 -10000 N P V @ 14%

N om inal C ash F low s (R s) C1 C2 C3 3210 3434.7 3675.13 266

C4 3932.39

Risk in Capital Budgeting

Sensitivity A nalysis: Sensor Corporation Initial Investment (Rs) Life of the project (Years) Discount Rate Operating Level (Nos) Selling Price falls by Selling Price (Rs) Revenue Variable Cost Contribution Fixed Costs Depreciation PBIT Interest PBT Tax @ 40% PAT Cash flow from Operations PV of Cash in flows Net Present Value at 15% Fall in NPV for 1% fall in selling price % fall in NPV for 1% fall in selling price 8,000 10 15% 3,000 3.2 8,000 10 15% 3,000 5% 3.04 8,000 10 15% 3,000 10% 2.88 8,640 5,400 3,240 1,200 1,200 840 ---840 336 504 1,704 8,552 552 -289 -8.40% 8,000 8,000 10 10 15% 15% 3,000 3,000 15% 20% 2.72 2.56 (Figure in Rs) 8,160 7,680 5,400 5,400 2,760 2,280 1,200 1,200 1,200 1,200 360 -120 ------360 -120 144 -48 216 -72 1,416 1,128 7,107 5,661 -893 -2,339

9,600 9,120 5,400 5,400 4,200 3,720 1,200 1,200 1,200 1,200 1,800 1,320 ------1,800 1,320 720 528 1,080 792 2,280 1,992 11,443 9,997 3,443 1,997 Sensitivity

Risk in Capital Budgeting

Initial Investm (R ent s) Life of the project (Y ears) D iscount R ate O erating Level (N s) p o S elling P rice (R s) R evenue V ariable C ost C tribution on F ixed C sts o D recia ep tion P IT B Intere st P T B Tax @40 % P T A C ash flowfromO peration s N P sent V et re alue at 15% C ng in N V for 1% ha e P change in varia ble %fall in N V for 1%fa in P ll selling price -8.40% C st o o f In itial co st cap ital in reases c in creas es N rm o al by 10% b 10% y 8000 8800 8000 10 10 10 15 % 15% 16.50% 3000 3000 3000 3 .2 3.2 3.2 9600 5400 4200 1200 1200 1800 1800 720 1080 2280 3443 Sn e sitivity 9600 5400 4200 1200 1320 1680 1680 672 1008 2328 2884 9600 5400 4200 1200 1200 1800 1800 720 1080 2280 2818 V ariab le c st o F ixed co st in as cre es in creases b 10% y b 1 y 0% 8000 8000 10 10 15% 15% 3000 3000 3.2 3.2 9600 5940 3660 1200 1200 1260 1260 50 4 75 6 1956 1817 9600 5400 4200 1320 1200 1680 1680 672 1008 2208 3082

-5 6

-63

-16 3

-36

-1.62 %

-1.82%

-4.78%

-1 .05%

Risk in Capital Budgeting

D m n L v l (n .s e a d ee o ) S llin P e (R ./u it) e g ric s n V ria lec s a b ot Oe e d v rh a s In l In e tm n (R ) itia v s e t s L o th p je t (Y a ) ife f e ro c e rs D c u t R te is o n a Se a c n rio O e tin L v l (N s p ra g e e o ) S llin P e(R ) e g ric s Rv n e eeu V ria leC s a b ot Cn u n o trib tio F e Cs ix d o ts D p c tio e re ia n P IT B In re t te s PT B T x@ 0 a 4% PT A C s flo fro O e tio s a h w m p ra n P s n V lu o C s inflo s re e t a e f a h w N t P s n V lu e re e t a e P b b (% ro a ility ) E p c dN V x e te P S n a D v io o N V ta d rd e ia n f P C e ie t o V ria n o ffic n f a tio E c lle t xe n 1% 0 5 % 1% 0 5 % Go od 5 % sm a e sm a e -5 % N rm l o a 30 00 3 .2 50 40 10 20 80 00 1 0 1% 5 N rm l o a 30 00 3 0 .2 90 60 50 40 40 20 10 20 10 20 10 80 0 10 80 70 2 18 00 28 20 143 14 34 43 3% 0 17 98 Bd a -5 % -5 % sm a e 1% 0 80 00 1 0 1% 5 Bd a 25 80 3 4 .0 86 64 50 40 36 24 12 30 10 20 74 4 0 74 4 27 9 .6 46 4 .4 1 4 .4 66 86 23 23 6 2% 0 W rs o t -1 % 0 -1 % 0 1% 0 2% 0 80 00 1 0 1% 5 W rs o t 20 70 2 8 .8 77 76 54 90 13 86 14 40 10 20 -8 4 0 0 -8 4 0 -3 1 2 .6 -4 2 8 .4 77 1 .6 30 61 -4 9 39 1% 5 10 67 0 1 .8

S e a A a s : S n o r C rp ra n c n rio n ly is e s n o o tio 80 00 80 00 1 0 1 0 1% 5 1% 5 E c lle t xe n 30 30 3 6 .3 108 18 54 90 54 18 16 20 10 20 28 68 0 28 68 1 7 .2 05 1 1 .8 62 2 1 .8 82 117 41 61 17 1% 5 Go od 35 10 3 0 .0 95 40 50 40 45 00 14 10 10 20 11 70 0 11 70 64 8 12 06 22 26 112 17 37 12 2% 0